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It takes you through the key principles that the study of behavioural finance has revealed. How taking simplified decision making on complex topics can lead to unexpected investment outcomes. From reading this guide you will gain an understanding of how to work with your financial adviser to help you overcome your own financial biases. How attitudes towards risk and reward can lead to behaviours that can inhibit investing success. including: 1 2 How overconfidence can negatively affect investment decisions. 3 4 1 .This guide discusses how human emotions and behaviours can affect investment decisions. How inertia can stop people from saving or making necessary changes to their investments.
3 4 6 8 10 12 14 16 18 19 What is ‘behavioural finance’? How biases affect investing behaviour Overconfidence Loss aversion The problem of inertia Mental shortcuts Using investing shortcuts The misuse of information What next? Bibliography and further reading 2 .
In other words. Human nature usually serves us well in coping with day-to-day life. avoid major pitfalls. But it can also get in the way of achieving success in long-term activities. Behavioural finance extends this analysis to the role of biases in decision making. 3 . and your adviser. such as saving and investing. such as the use of simple rules of thumb for making complex investment decisions. People in the world of investments commonly talk about the role greed and fear play in driving stock markets. but greater awareness of biases can help you.What is ‘behavioural finance’? Most people know that emotions affect investment decisions. behavioural finance uses psychology to understand how people make investing decisions. There is no ‘cure’ for human nature.
they affect all types of investors. to avoid loss or regret. both professional and private. Investing Avoiding trying to understand complex topics. Many of these also affect decisions about money and investing. which can lead to inappropriate or risky investments. at all costs. which can mean we either don’t save for the future. Some of the key biases that affect financial decisions include: Investing with overconfidence. investing decisions altogether. Understanding them can help you and your adviser work together to learn to work around them. or we stick with an inappropriate strategy. which can lead us to make uninformed decisions. These biases sit deep within our psyche and as fundamental parts of human nature. which can mean we don’t invest in way that will truly help us reach our investment objectives. This guide briefly explores how some of these biases work. This can mean we have less chance of meeting investment objectives.How biases affect investing behaviour Psychological research has documented a range of biases that can affect decision making. Avoiding 4 .
these behaviours affect all types of investors. 5 .The behaviours sit deep within our psyche. They may lead us to unhelpful decisions. both professional and private. As a fundamental part of human nature. Understanding them can help you and your adviser work together to learn to overcome them.
it can also become an ongoing source of poor decision making.1 Overconfidence is closely related to the human tendency to view the world in positive terms. This can’t be true because. Many studies have also found that overconfidence affects people from all walks of life. All these groups tend to overrate the accuracy of their own ability to predict the future. The courage of misguided convictions’ Financial Analysts Journal. 6 1 Barber and Odean (1999). 50% of drivers are below average. November/December. . lawyers and students. For example. Not everyone can be above average It appears that everyone is susceptible to overconfidence in life and rate themselves much higher than any objective measure would. While this can help you recover from life’s disappointments more quickly. doctors. such as chief executives. researchers found that most people rate themselves in the top third of the population in terms of driving ability. by definition.Overconfidence Psychology has found that people tend to have unjustified confidence in their abilities and decisions. p47.
7 . Too much risk – Many investors fall into the trap of believing they can pick winning investments. which can be very risky. Research shows that those who buy and sell often were at a disadvantage compared to those who take a long-term view. Working with your adviser Your financial adviser can help you avoid overconfidence and give you an objective perspective on your investment decisions. which can have a negative effect on their returns. As a result. we tend to see this as just bad luck or misfortune. Research shows that picking winning investments is incredibly hard to do. Too much trading – Investors with too much confidence in their skills often buy and sell too often. However. even for professional investors. they sometimes put too much of their wealth in a single pot. we claim the credit. Mistaking luck for skill – When something turns out well after a decision we’ve made.Overconfidence and investing Overconfidence can cause real problems for investors. when something goes badly.
However. For further detail on the nature of investment risk you may wish to refer to our separate investor education guide entitled Investment risk.co. Balancing investment risk and potential reward. 8 . It can also change over time and in different circumstances. Your tolerance to risk tends to drive the types of investments they recommend for you.uk. the human attitude to risk and reward can be very complex and subtle. available on vanguard. Attitudes to risk and reward Financial advisers will normally ask you to complete a questionnaire to establish your attitude to risk.Loss aversion The human tendency to take extreme measures to avoid loss leads to some behaviours that can inhibit investing success.
In practice. As a result. the tendency to sell winning investments and hang on to losing investments has a negative impact on investing returns. This means that investors sometimes hold on to losing investments hoping they will recover their losses while quickly selling winners to realise a gain. Working with your adviser Your adviser has a key role in helping you deal with fear of loss and contain your desire to sell winners and hold losing investments. investors’ ‘risk profile’ changed depending on whether they are facing a loss or a profit. They can help you evaluate whether the investment still has good future prospects and whether it still suits your particular circumstances.Fear of loss Behavioural finance suggests investors are more sensitive to loss than to risk and potential return. 9 .
which is often ‘wait and see’. inertia has a positive use. probably due to inertia. boosts pensions scheme enrolment.The problem of inertia Inertia means that people fail to get around to taking action. the tendency to procrastinate dominates financial decisions. In this case. Automatically enrolling employees in the pension scheme. Uncertainty can lead people to choose the path of least resistance. Inertia can act as a barrier to effective financial planning. For example. 10 . even on things they want or have agreed to do. many individuals fail to join their company pension plan. Uncertainty and confusion Confusion about how to proceed lies at the heart of inertia. Overcoming inertia with an autopilot In recent years behavioural researchers have designed ‘autopilot’ systems to help overcome this bias. even when there is a clear chance to opt out. so common in many aspects of our daily lives. In this pattern of behaviour. stopping people from saving or making necessary changes to their investments.
to guide decisions can help investors to avoid being swayed by current market conditions. Such disciplined approaches can help investors avoid biases like overconfidence and promote more rational behaviour. such as an annual review. Working with your adviser Regular investment schemes and automatic investment reviews are approaches that your adviser can help put in place to help you overcome inertia and keep you on track for meeting your investment objectives. Regular investing also helps as the investor tends to accumulate more units or shares of an investment when markets are low than when they are high. such as committing to regular monthly investments.Autopilot approaches to investing Autopilot approaches can also have relevance in investing. such as the recent performance of a ‘hot’ investment. 11 . Using a set schedule.
Mental shortcuts Most people use ‘mental short cuts’ or take very ‘narrow’ views of their investments. This can help avoid making potentially unhelpful short-term investment decisions. investors often overreact when one of those investments goes through a bad patch. can help investors to accept short-term losses in individual securities in the pursuit of their long-term financial goal. As a result. when taking a ‘wide’ focus and viewing their portfolio as a whole. Narrow focus People tend to focus on the behaviour of individual investments. This can have a negative impact on investment decisions. However. 12 .
They can also help you to evaluate your financial standing and avoid focusing too much on individual investments. Your adviser could focus on your individual mental accounts and perhaps assign individual risk profiles and objectives to each account. in terms of our entire wealth position. We often base these pools on a specific goals or time horizon (such as ‘retirement’. 13 . investing some in risky assets for gain while treating others more conservatively. We think very differently about each mental account. This can cause us to focus on the individual buckets rather than thinking broadly.Mental accounting We often separate our money and financial risk into ‘mental accounts’ – putting our wealth into various ‘buckets’. ‘school fees’ or ‘new sports car’). Working with your adviser Working with your adviser to understand the human tendency for mental accounting may lead to better investing decisions.
they go for a simple approach.Using investing shortcuts Your adviser understands the importance of holding a mix of investments in proportions that reflect your particular circumstances. behavioural finance suggests investors struggle to apply the concept in practice. This can lead to a mix of investments that may not match the investor’s actual risk tolerance or ultimately meet their investment objective. Simplistic ‘rules of thumb’ Evidence suggests that investors use simplistic ‘rules of thumb’ when structuring their investments. Investors might understand the importance of holding a broad mix of investments. they might invest equal amounts in a number of different investments in equal proportion. For example. but not knowing exactly how to go about it. ignoring the risk-return profile of each and the relationships between them. However. 14 .
Investing in the familiar People tend to like to invest in things that are familiar. 15 . although recent market falls may have changed this perspective. For example. investors in the UK might tend to prefer to invest in UK companies. They associate investments that they know about with low risk. Working with your adviser Your adviser can help you achieve a broad mix of investments and avoid concentrating risk in particular investments. for example. The danger with this approach is that your portfolio may not be diverse enough to help offset falls in any one type of investment or market. in the UK in recent years. the familiarity of property may have caused many investors to underestimate the risks involved. So. They can help you understand why familiarity is not a substitute for a good spread of investments.
We tend to apply simplified decision-making strategies to complex situations. 16 . Numbers. seem to attract disproportionate interest. but in some cases they can mislead us. large round numbers can act as anchors for investing. The recent memory makes the prospect more vivid. To give a financial example. people tend to feel they have a greater chance of having a car crash if they’ve seen one recently. For example. despite just being numbers like any other.The misuse of information Behavioural finance identifies the ways we tend to filter out and misuse information when investing. investors are more likely to be fearful of a stock market crash when one has occurred in the recent past. Information ‘anchors’ Decisions can be ‘anchored’ by the way information is presented. For example.000 points on the FTSE 100. such as 5. Recent events Some evidence suggests that recently observed or experienced events strongly influence decisions. and therefore seem more likely. Sometimes these strategies are helpful.
rather than take a longer term view. For example. A common financial example would be assuming that the past performance of an investment is an indication of its future performance. Conservatism People often take a very conservative approach to changing their minds after taking a decision. despite new contradictory information.Superficial decision making Sometimes we make decisions based on a situation’s superficial characteristics (what it looks like) rather than a detailed evaluation of the reality. Another way of putting this would be saying that decisions are made based on stereotypes. investors who invest in a high-profile company may be slow to adjust their view of the company’s prospects even after the company’s profitability declines. Working with your adviser Advisers can help you avoid misusing or simplifying information by putting it in context. People also tend to look at short-term investment performance and believe it will continue. when in fact past performance should never be relied upon as an indicator of future returns. Some advisers use checklists to help identify these types of potential investment pitfalls. 17 .
which tend to detract from investment success. 18 . We’ve discussed a range of deep-seated human behaviours.What next? This guide has described behavioural finance and what it means for you as you work with your adviser to create a plan that will help you reach your financial goals. With this knowledge you should be better prepared to work with your financial adviser when constructing a long-term investment plan with a better chance of meeting your investment goals.
.Bibliography and further reading If you want to explore behavioural finance in more detail you might find the following books of interest. 2008. Your money and your brain. For a more detailed but accessible introduction to behavioural finance try: Shefrin. Beyond Greed and Fear: Finance and the Psychology of Investing. Nudge: Improving Decisions about Health. 2007. Hersh. read: Zweig. Jason. For a more general discussion of the role of behavioural economics consider: Thaler. Wealth and Happiness. 2000. Richard and Sunstein. Cass. For a fascinating review of the recent research from the emerging field of neuroeconomics.
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